“This is the year the tortoise may gain on the hare.”
There are a lot of data points that one can observer to get a sense of the venture capital markets – both LP fundings into venture and VC financings of startups. They point to some widely known facts: financings & valuations are up massively over the past 7 years and non-VC money has entered the system.
But these data points are often lagging indicators and perhaps a better barometer of the future would be to gather data on VC perceptions in the market right now. Of course sentiment can swing wildly with new information but I set out to take the pulse of the market as we enter 2016.
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State of the Market
Let’s start with some basic data most people know. Limited Partners (LPs) who invest in VC funds have continued to pour money into venture – with the market returning to pre-recession levels.
Don’t be fooled by the slight dip in 2015 – the size of funds & timing of deals in market in any year can skew the data set. My conversations with LPs tell me that 2016 is one of their business calendars in years and unless we see an unexpected, sudden downturn expect the market size in 2016 to remain at current levels or increase.
How do I know? We surveyed 73 LP firms to get their views on the market. While the data from LPs makes it clear that they have concerns about the pace by which VC firms will invest, 82% said they expected to keep the same pace, which 8% suggested they would increase investments. I would also point out that with corporates investing in more VC funds and Chinese money looking for stability, it’s entirely possible totally new money enters our system.
But LP dollars into VC isn’t really “the story” – the biggest shift in the past decade is the amount of “non-VC” investment that has gone into venture-backed tech startups. Let’s start with the money slide:
10 years ago there was about the same money pouring into VC as found its way into startups but in the past two years 2.5 times the dollars went into venture-backed startups as went the money that poured into venture. This isn’t an “emptying out of the VC coffers” but rather new participants pushing their chips onto the table with relatively less experience at doing so.
The result of all of this new money? Median pre-money valuations skyrocketed – shooting up 3x in just three years as investors competed to christen imaginary animals with imaginary valuations. And then at once the market felt constipated – just look at Q415.
Sentiment of the Market
So what happened?
As I’ve argued for ages there has to be a correlation between public tech stock valuations and private market valuations. Of course this doesn’t mean private market valuations will follow the same p/e or p/s ratios – they won’t because the expectation is for much higher growth rates in private companies. But it seemed like the correlation became completely untethered in the past 3 years and that’s nonsense.
So why the slow down all of a sudden? Leaving aside China, oil prices, Syrian refugees, a presidential election and all of the things that might feed into general market fear – this chart is telling
Frankly, it’s really hard to write checks at later-stage valuations when you know you’ll have to exit into the public markets or sell to a public-market company one day and the stocks are declining precipitously.
But again, this may still be lagging indicators or the canary in the coal mine. When we surveyed more than 150 VC firms for what they were seeing in the market, the data were pretty clear.
61% of VCs said valuations were “marginally down” in Q4 of 2015 but 91% expect price decreases in the next two quarters. The anecdotal sentiment I hear from A/B investors trying to get companies financed is that they’re encouraging founders to be “flexible” or “realistic” and the sentiment has clearly shifted from “scale as fast as you can” to “lower burn and make sure you have 18-24 months of cash.”
How seriously is the “lower your burn message?” It was actually much louder than I expected. I’ve been giving every company I talk to the sermon about burn rates and returning to pragmatic growth but I underestimated how many of my peers had already started to do the same. In fact, 62% of VCs surveyed – across a wide variety of stages and geographies – said their portfolios were starting to cut costs, expected the markets to tighten.
And of course all of these factors are related. If median valuations are down massively, later-stage investors are staring at their trading terminals and fund-raisings are taking longer – of course companies must cut burn rates. And to give you a sense of how long it will take companies to get funded, note that in Q4 of 2015 45% of investors noted it was taking longer to get deals funded. And the outlook for 2016 shows 77% of VCs expect it to take even longer in the months ahead.
Some Likely Conclusions
Well, we call know that Jon Snow probably isn’t really dead, but one thing you can count on …
I just don’t know whether it will be super cold or El Niño or something altogether different. But it’s certainly not sunny ahead.
What to expect in the next 24 months? It’s only a guess, but mine would be:
- Increased loss ratios
- Most flat rounds
- More down rounds
- More structured rounds
- Relatively harder to raise capital
- VCs marking-to-market showing some movements south
In short, a slight clearing out of some older, weaker branches washed out by the storm. And while we should never celebrate this, we all know the cycle of renewal clears the way for need seedlings, new growth and a more realistic cohort of first-time entrepreneurs raised to be careful about every incremental dollar of spend.
Expect the tortoise to make progress against the rabbit.
But none of us are in this business for the short-term ebbs-and-flows. We know that we must fund companies in good times and bad and across economic cycles. In many ways this favors venture capital over other less patient or short-term forms of capital. And just as we get despondent from the things that are working less well than we’d like, we fall in love again with a new group of innovations and innovators and disruptors in the inevitable march towards technology progress.
Note: A full version of this presentation can be downloaded on SlideShare – or viewed below – with the full analysis.
(Cross-posted @ Both Sides of the Table)